Psychological biases help us deal with the real world, but they can lead us astray when it comes to investing.

There are many questions investors would love to have answered. Will interest rates rise? Will the economy continue to grow? Will the stock market remain strong? All that uncertainty makes it hard to make investment decisions. As a result, affluent investors tend to become increasingly influenced by their emotional biases, which can often lead them astray.

"Cognitive biases are a result of the mechanisms we've developed to deal with a complex world with complex relationships," says Meir Statman, Glenn Klimek Professor of Finance at Santa Clara University and author of What Investors Really Want. “But they are particularly ill-suited for making investment decisions."

Biased investing

Overconfidence is a prime example of this type of emotional bias. If you've been successful as an entrepreneur or a surgeon, or in some other high-earning career, chances are you achieved that success in part because of confidence in your own abilities.

However, the same confidence that helps people excel in their careers can lead them astray when considering investment decisions. “In any trade, someone will win and someone will lose," says Statman. “Overconfidence makes both parties assume they're the one that will win."

Recency bias—the tendency to lend greater weight to recent experiences than experiences from the past—is another way in which emotions can interfere with investment decisions. This bias helps people process a lot of information by honing in on what is most immediate. In investing, however, this bias makes us likely to focus on short-term price movements, rather than taking a longer term view.

When combined with overconfidence, recency bias can encourage investors to follow the herd. They might rush into the stock market, for example, just as a rally is about to wind down.

Confirmation bias can also get in the way of rational investing behavior. People have a tendency to seek out sources of information that confirm their point of view and exclude the information that disproves it. By way of example, Statman points to the media's tendency to focus on market analysts who correctly predict future stock performance, rarely noting how often these same analysts have guessed incorrectly in the past.

“We look back with perfect hindsight and then assume we can look forward and make accurate predictions," he says. “For example, we think the markets are headed up, so we choose to focus on all the data that supports that hypothesis."

Managing our emotions

Biases are an integral part of how the brain processes information. As a result, it's impossible to completely exclude them from the decision-making process, but investors can make an effort to avoid situations in which their cognitive biases are likely to lead them astray.

For instance, strategies such as dollar-cost averaging and investing in low-cost index funds may remove many of the opportunities for emotions to trip up investment decisions, simply because these strategies limit the number of decisions an investor needs to make.

High-net-worth investors may find active management and strategic investing more appealing than low-cost, passive approaches. If that's true for you, says Statman, try to rely on the scientific process when making investment plans. “Apply logic and empirical evidence to your decisions," he says. That means investing based on fundamentals and taking a long-term approach to your investments, such as implementing a buy-and-hold strategy rather than trading more frequently.

In a rational world where all information is known to all parties, there is no risk and there is little opportunity for our biases to lead us astray. However, the markets are not rational, and no one has all of the information. As a result, investors must try to counter the decision-making processes that have evolved to help people navigate the natural world.

“Working against our intuition is hard," says Statman. “But when you are aware of some of the patterns of how we think, you can work to counter them."

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